Harvard Teaches Us That Hedge Fund Managers Get Rich Even When They Mess Up

While we all know that it is important for people to get a good education if they want to do well in today's economy, it remains the case that who you know matters much more than what you know. Harvard has taught us this lesson well with the management of its endowment in recent years.

Businessweek reported that the returns on Harvard's endowment over the last decade averaged just 4.4 percent annually. This performance trailed both stock index returns and the returns received by other major university endowments. This means that Harvard would have had considerably more money to pay its faculty and staff if it simply bought a Vanguard index fund.

If this were just bad luck, one could be sympathetic, but according to Businessweek, the school paid $242 million to the people who managed its money over the period from 2010 to 2014, an average of $48.4 million annually. While Harvard's endowment fared poorly, these money managers did very well, with the top-paid managers undoubtedly pocketing paychecks well in excess of $1 million a year (approximately 8,000 food stamp months). In other words, Harvard's money managers were paid huge sums to lose the school money. Nice work if you can get it.

It is difficult to understand how Harvard, or any university, could pay so much money to lose the school money. Harvard's money managers surely have good credentials, and probably even good track records with their past performance. How could the university write contracts that allow these people to get huge paychecks that end up costing Harvard money due to their poor investment decisions?

Unfortunately, universities are not the only ones who often pay big bucks to lose money. Pension funds routinely sign contracts with private equity companies that allow the private equity partners to get rich even if investment returns to the funds are no better, and often worse, than the returns from equivalent stock index funds. The key is to be on the inside: a well-connected private equity fund manager. Being able to find good investment opportunities is secondary.

It is not only the financial sector where good contacts mean everything. The story of the exploding pay of top corporate executives is also largely a story of friends in high places. CEOs have always been well-paid, but in the last four decades their pay went from being in a range of 20 to 30 times the pay of a typical worker, to being 200 to 300 times the pay of a typical worker.

The deal with CEOs and other top management is that they play a large role in selecting the members of the corporate boards that oversee their work and set their pay. Being a director of a major corporation is an incredibly cushy job. It involves around 100 to 150 hours of work a year and typically pays over $100,000 a year and can pay $200,000 or $300,000 a year.

Directors can generally count on keeping their jobs as long as they stay on the good side of their peers and top management. In principle, shareholders get to vote on whether directors should be retained. In practice, more than 99 percent of the directors who are put forward by the board are re-elected.

In this environment, there is little incentive for directors to ask questions like, "can we get away with paying our CEO less money?" Even though it is supposed to be the responsibility of the director to shareholders to minimize the pay to CEOs, few directors seem to take this aspect of their job seriously. They have no incentive to try to push down the pay CEOs receive. As a result, we see a continuing upward spiral of CEO pay, where the high pay of one CEO can provide the basis for raising the pay of a competitor. However, low CEO pay in one company is rarely used as a basis for cutting the pay of a CEO elsewhere.

And, this is a big deal. When the CEO gets $20 million a year, the next tier of corporate management will likely get paychecks well into the millions, with third-tier paychecks at least in the high hundreds of thousands. It is basic logic that the more money the folks at the top get, the less money is available for everyone else. The chief financial officer may get a jump in pay that corresponds to the raise received by her CEO; the custodian almost certainly will not.

In short, as Harvard teaches us, the key is to get into the right social circles. While performance may still be rewarded, it is not necessary, as Harvard's money managers demonstrate so well.